Finance: Weighted Average Cost of Capital and Market Risk Premium
Cost of Capital questions and practice problems
Questions
1. What does the WACC measure?
2. Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume you are an outsider to the firm.
3. Why are market-based weights important?
4. Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital?
5. Under what assumptions can the WACC be used to value a project?
6. How should you value a project in a line of business with risk that is different than the average risk of your firm’s projects?
7. Maltese Falcone, has not checked its weighted average cost of capital for four years. Firm management claims that since Maltese has not had to raise capital for new projects since that time, they should not have to worry about their current weighted average cost of capital since they have essentially locked in their cost of capital. Critique this statement.
8. Your manager just finished computing your firm’s weighted average cost of capital. He is relieved because he says that he cannot use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate this statement.
9. How should you adjust for the cost of raising external financing? (floatation costs)
10. Geothermal’s WACC I 11.4%. Executive Fruit’s WACC is 12.3 percent. Now executive Fruit is considering an investment in geothermal power production. Should it discount project cash flows at 12.3%? Why or why not?
11. An analyst at Dawn Chemical notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some project that would have seemed attractive if
Questions
1. What does the WACC measure?
2. Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume you are an outsider to the firm.
3. Why are market-based weights important?
4. Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital?
5. Under what assumptions can the WACC be used to value a project?
6. How should you value a project in a line of business with risk that is different than the average risk of your firm’s projects?
7. Maltese Falcone, has not checked its weighted average cost of capital for four years. Firm management claims that since Maltese has not had to raise capital for new projects since that time, they should not have to worry about their current weighted average cost of capital since they have essentially locked in their cost of capital. Critique this statement.
8. Your manager just finished computing your firm’s weighted average cost of capital. He is relieved because he says that he cannot use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate this statement.
9. How should you adjust for the cost of raising external financing? (floatation costs)
10. Geothermal’s WACC I 11.4%. Executive Fruit’s WACC is 12.3 percent. Now executive Fruit is considering an investment in geothermal power production. Should it discount project cash flows at 12.3%? Why or why not?
11. An analyst at Dawn Chemical notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some project that would have seemed attractive if